Partnership § 754 Basis Adjustment

A § 754 election allows a partnership to adjust the inside basis of its assets whenever a partner sells their partnership interest (§ 743) or when the partnership makes a property distribution (§ 734) — closing the gap between what a new partner paid for their interest and their share of the partnership's underlying asset basis. Without the election, a buyer paying $1 million for a partnership interest gets no adjustment to their share of inside basis even if the partnership's assets are still carried at their original cost from decades ago — meaning the new partner would pay capital gains tax again on appreciation that already occurred before they bought in. With a § 754 election in place, 26 U.S.C. § 743 requires the partnership to step up (or down) the new partner's allocable share of inside basis to match what they paid, eliminating this "phantom gain" problem. The election is made once and is irrevocable without IRS consent, applying permanently to all future transfers and distributions. For partnerships holding real estate, private equity assets, or any long-held appreciating property, the § 754 election is one of the most consequential decisions in the partnership's tax life — getting it right at formation or early in the partnership's life can save incoming partners millions of dollars in duplicated capital gains taxes.

Current Law (2026)

Parameter	Value
Governing statute	26 U.S.C. § 754 (election); § 743 (transfer of interest adjustments); § 734 (distribution adjustments)
§ 743 adjustment	Triggered when a partner sells/transfers their interest; adjusts new partner's share of inside basis to match what they paid
§ 734 adjustment	Triggered when partnership distributes property; adjusts inside basis when gain/loss recognized or basis discrepancy arises on distribution
Election mechanics	Made by the partnership filing a statement with its tax return for the year of the triggering transfer
Irrevocability	Once made, election applies to all future transfers and distributions; cannot be revoked without IRS permission
Mandatory adjustment	If partnership has "substantial built-in loss" (>$250,000 unrealized loss), § 743 basis adjustment is mandatory regardless of election
Mandatory downward	If distributed property has basis >FMV by >$250,000, § 734 downward adjustment is mandatory
Large partnership exception	Partnerships with >100 partners have been subject to varying rules; TCJA tightened mandatory adjustment thresholds
Basis adjustment allocation	Allocated among partnership assets using § 755 rules (ordinary income assets vs. capital/1231 assets)
Recordkeeping	Adjustments tracked per-partner, creating separate "tax books" for each buying partner

Key Mechanics

A § 754 election allows a partnership to adjust the inside basis of its assets to match a transferee partner's outside basis, eliminating phantom gain or loss. When a partner buys a partnership interest for $2 million but inherits only $500,000 of inside basis, a § 743(b) adjustment steps up that partner's allocable share of inside basis by $1.5 million — so they pay no tax on appreciation that occurred before they bought in. The election, once made on a timely filed return, applies to all future transfers and distributions and is revocable only with IRS permission. § 734(b) applies the same principle after distributions: if a partner recognizes gain on a distribution (cash exceeds outside basis) or receives property whose carryover basis differs from FMV, the partnership adjusts the inside basis of remaining assets. § 743(d) and § 734(b) mandate adjustments even without an election when the partnership has a built-in loss exceeding $250,000 (outside basis exceeds FMV by more than $250,000) or a substantial basis reduction. The total adjustment is then allocated among specific partnership assets under § 755: first to ordinary income assets (receivables, inventory), then to capital and § 1231 assets (real estate, securities), preserving the character of future income or gain.

Legal Authority

26 U.S.C. § 754 — The election provision: authorizes partnerships to elect to apply §§ 734(b) and 743(b) to adjust the basis of partnership property; the election is made by attaching a statement to the partnership's timely filed return for the tax year of the triggering event
26 U.S.C. § 743(b) — Transfer of interest in partnership: when a § 754 election is in effect, the partnership adjusts the inside basis of its assets with respect to the transferee partner by the difference between the transferee's outside basis (what they paid) and their share of inside basis (partnership's book value)
26 U.S.C. § 743(d) — Mandatory adjustment for substantial built-in loss: if, immediately after a transfer, the partnership has a built-in loss exceeding $250,000 (FMV of assets less their adjusted basis), the partnership must make the § 743(b) adjustment regardless of whether a § 754 election exists
26 U.S.C. § 734(b) — Adjustment to basis of undistributed partnership property: after a distribution, if a partner recognizes gain (cash distribution exceeds outside basis) or loss, or if distributed property's carryover basis differs from its FMV, the partnership adjusts inside basis of remaining assets
26 U.S.C. § 755 — Rules for allocation of basis: after computing the total § 743(b) or § 734(b) adjustment, § 755 allocates that adjustment among specific partnership assets — ordinary income assets (receivables, inventory) get the adjustment first, then capital and § 1231 assets (real estate, securities)
26 U.S.C. § 754 (DB) — Manner of electing optional adjustment to basis of partnership property: if a partnership files an election under IRS rules, the basis of partnership property shall be adjusted for distributions (§ 734) and transfers of a partner's interest (§ 743); the election applies to the year filed and all subsequent years and may be revoked only with IRS permission
26 U.S.C. § 743 (DB) — Special rules where section 754 election or substantial built-in loss: a "substantial built-in loss" exists when the partnership's tax basis in its assets exceeds fair market value by more than $250,000, or when the new partner would be allocated more than $250,000 of loss if assets were sold immediately; securitization partnerships are excluded from the substantial built-in loss rules
26 U.S.C. § 734 (DB) — Adjustment to basis of undistributed partnership property: a "substantial basis reduction" requiring mandatory adjustment occurs when the downward adjustments to inside basis total more than $250,000; securitization partnerships are never treated as having a substantial basis reduction for any distribution

How It Works

The phantom gain problem without § 754: Suppose a real estate partnership bought a building in 1995 for $1 million. Today the building is worth $4 million. Partner A, who owns 50%, sells their interest to Partner B for $2 million (50% of $4 million value). Partner B's outside basis in the partnership interest is $2 million. But inside — in the partnership's books — the building still shows a $1 million cost basis. Partner B's 50% share of inside basis is only $500,000. If the partnership sells the building tomorrow, it recognizes a $3 million gain. Partner B's 50% share is $1.5 million — even though Partner B just paid $2 million for an interest worth exactly $2 million and had zero economic gain. This is phantom gain: Partner B pays capital gains tax on appreciation that occurred before they bought in.

With a § 754 election: When Partner B buys the interest for $2 million, the partnership makes a § 743(b) adjustment specific to Partner B's interest. Partner B's outside basis ($2 million) exceeds their share of inside basis ($500,000) by $1.5 million. The partnership steps up the inside basis allocable to Partner B by $1.5 million — the building's basis in Partner B's tax books is now $2 million (their 50% share), not $500,000. If the partnership sells the building, Partner B recognizes zero gain. The phantom gain is eliminated.

The § 734(b) distribution adjustment: When a partnership distributes property, the distributing partner's outside basis may be reduced below the property's carryover basis — or a partner may recognize gain on a cash distribution exceeding outside basis. The § 734(b) adjustment keeps the partnership's inside basis aligned after distributions. If a distribution causes a partner to recognize gain (or loss in a liquidating distribution), the partnership adjusts the inside basis of remaining assets upward (if gain recognized) or downward (if loss) to prevent double-counting.

The § 755 allocation among assets: The total § 743(b) adjustment must be allocated among the partnership's specific assets. This allocation matters because the character of the adjusted asset determines how the partner benefits: a basis step-up on a depreciable building generates future depreciation deductions; a step-up on land does not. The § 755 regulations require allocating the adjustment first to ordinary income assets (in the same proportion that the adjustment would reduce ordinary income on a hypothetical liquidation), with the remainder allocated to capital and § 1231 assets.

Making the election: The § 754 election is made by attaching a statement to the partnership's tax return for the year of the first triggering event (transfer or distribution). The statement must declare that the partnership elects under § 754 to apply §§ 734(b) and 743(b). Once made, the election applies to all future transfers and distributions — not just the one that triggered it. Revoking the election requires IRS permission, typically granted only with demonstrated undue administrative hardship.

Mandatory adjustments: Even without a § 754 election, § 743(d) mandates basis adjustment when the partnership has a "substantial built-in loss" — the total FMV of partnership assets is less than their adjusted basis by more than $250,000. Similarly, § 734(b) mandates adjustment for substantial basis reductions after distributions. These mandatory rules prevent partnerships from using transfers or distributions to shift built-in losses to other partners.

How It Affects You

If you are buying into a real estate partnership or private equity fund: Before closing, ask whether the partnership has a § 754 election in place. If it doesn't, you may pay capital gains tax on appreciation that occurred before you joined. Request a "§ 743 analysis" showing the difference between your purchase price and your allocable share of inside basis — this is the "phantom gain" you'd face without the election. If the partnership lacks a § 754 election and has significant built-in appreciation, negotiate either for the partnership to make the election as a condition of your investment, or for a price reduction reflecting the phantom gain you'll absorb. For real estate partnerships with appreciated assets, the absence of a § 754 election is a material economic disadvantage to incoming partners that should be priced into any acquisition.

If you are managing a real estate or private equity partnership: Making the § 754 election at formation (or after the first transfer) is almost always in new investors' interest and rarely hurts the partnership itself. The administrative burden — maintaining separate "tax books" for each partner who bought in at different times — is real but manageable with modern partnership tax software. Failing to make the election when new investors join at appreciated values creates a structural disadvantage that makes your fund less attractive to sophisticated investors. Most institutionally managed real estate funds and private equity funds maintain § 754 elections.

If you are selling your partnership interest: A § 754 election benefits your buyer, not you as seller. Your gain on the sale is determined by your outside basis (what you've paid and your share of liabilities) versus the amount realized — the § 754 election doesn't change your sale proceeds or gain. However, maintaining a § 754 election makes your fund more marketable because buyers know they won't absorb phantom gain. In the sale negotiation, the presence of a § 754 election may support a higher price because buyers are paying for the full economic value without a hidden future tax liability.

If you are a limited partner in a large private equity or real estate fund: The § 754 election and resulting § 743 adjustments should be reflected in the Schedule K-1 you receive from the fund. Line 13 (other deductions) or line 11 (other income) items labeled "§ 743(b) basis adjustment" represent your fund's accounting for your personal step-up. These adjustments reduce your future gain allocations or increase depreciation allocations — a direct tax benefit from the election. If your K-1 shows significant § 743(b) items, that reflects the fund's effort to accurately track your individual tax basis. Review these items carefully before preparing your return, and consider using a tax professional who specializes in partnership K-1s.

State Variations

Most states follow federal partnership basis rules, including § 754 elections:

CA: California generally conforms to federal § 754 election and § 743/734 basis adjustments. California-source gain from partnership asset sales is still subject to California income tax for all partners, including those who received § 743 step-ups — the step-up reduces California gain in the same manner as federal.
NY: New York follows federal § 754 treatment. New York-sourced partnership income (from real property located in New York) remains taxable to non-resident partners even with § 743 adjustments.
States without pass-through conformity: A small number of states have their own partnership tax rules that may not fully conform to federal § 754 mechanics. Partnerships with assets in multiple states should review state-specific rules.